ECON306: International Economics: 2014

Class Test One Solutions

Answer 1a:
The effect of an import tariff on factor returns under the specific factor model

South, small countries, by creating domestic distortions via an import tariff or an export subsidy,
hurt their own level of welfare. They may of course have a particular agenda or goal by engaging in
this type of policy (such as protecting the income of a certain group such as the income of the
scarce factor (capital), or increasing their market share in the world market, etc.), but the fact is
that there will be a net welfare loss from this type of policy, the cost to the rest of us from a
government policy to protect special interest groups, workers or whole industries.
Under the specific factors model, the returns to the factor specific to production in the industry
being protected rise (in the case of South’s protection via an import tariff imposed on capital-
intensive goods, implies that capital owners in South gain) whereas the returns to the factor specific
to production in the industry not being protected fall (in the case of South’s lack of protection on
land-intensive goods, implies that land owners in South lose). The return to the mobile factor in
production, namely: labour in South as a result of the protection is ambiguous. This resulting
effect on factor returns in South is the opposite to that under a policy of free trade where the factor
specific to the exporting industry gains and the factor specific to the importing industry loses.

Answer 1b:
The impact of trade on market size and economies of scale under monopolistic competition.

P = 17,000 + 150/N
AC = NF/S + c = N(5000 mill)/(300 mill + 534 mill) + 17,000

Setting P = AC and solving for N (number of firms):

17,000 + 150/N = N[5000 million/834 million] + 17,000
N= 5

P = 17,000 +150/5 = 17,030.

Answer 1c:
South Africa’s resource and trade position in a H-O theory context

The H-O theory predicts that for SA, exports will be intensive in the use of unskilled labour, the
factor which it is relatively richly endowed with in a global context and imports will be intensive
in the use of physical and human capital, factors with which it is relatively poorly endowed with in
a global context.

In reality, South Africa’s exporting of goods that are human and physical capital-intensive reveals
her as being richly endowed with these factors with in a global context which does not support the
H-O theory predictions. Furthermore the poor export performance of South Africa’s
manufacturing sectors which are labour and raw materials intensive is also a surprise as the HO
theory would predict a strong comparative advantage on the part of South Africa in these goods
within a global context.

South Africa’s actual trade position does not reflect her relative global resource endowment
position rendering the H-O theory inaccurate in predicting the source/s of her comparative
advantage. Rather the country’s trade position reflects a Leontief-type mismatch with
endowments in that exports are intensive in the use of her relatively scarce productive factors as
viewed from a global perspective.

An export strategy based on South Africa’s intensive use of unskilled labour (according to H-O
theory predicted comparative cost advantage) is not realized but is rather seen by market
commentators as a strategic response to the domestic constraints faced within the country. These
domestic constraints include:
historical factor market distortions which have resulted in the relatively high domestic cost of
unskilled labour and relatively low cost of physical capital.
low productivity levels amongst unskilled labour due to poor & inadequate education and
training of these workers.
strong trade unionization (and hence relatively high nominal wages relative to productivity
levels) for unskilled labour within the country.
trade policies which have historically protected the interests of human and physical capital
owners rather than unskilled workers interests.

Answer 2a:

Switzerland is capital-rich and Germany labour-rich based on the relative ratios of K/L for the two
countries: (2000/6000)Switz > (2500/12000)Germ.

Cellphones are capital-intensive and watches labour-intensive in production based on their factor-
use requirements: (2/5)cell > (2/10)watch.

The pattern of trade which emerges on the basis of factor endowment differences between the two
countries and the factor-usage differences of the commodities, is where Switzerland as the capital-
rich country has the comparative advantage in cellphones and hence exports this to Germany
whereas Germany as the labour-rich country has the comparative advantage in watches and exports
this to Switzerland.

According to the Stolper-Samuelson theorem, capital owners in Switzerland will be better off with
trade, as the relative returns to capital (being the abundant factor used in the production of the
cellphones for export) rises as the price of cellphones rises with trade. Recall, the reward (under
perfect competition) to any factor is based on the price of the commodity that factor produces and
the marginal productivity of that factor. Since both the price and quantity produced of cellphones
increases (which raise the marginal product of capital) in Switzerland as a result of trade, the
returns to capital owners rise.

Answer 2b:

TRUE….given a large country is a price-maker in world markets, the tariff can be used to improve
the terms of trade (price of exports/price of imports) that it faces….so as to potentially offset the
deadweight production and consumption efficiency loses that arise from the tariff’s imposition.
The tariff rate that accomplishes this is maximization of the large country’s national welfare is
known as the optimal tariff.
 With the tariff in place, the price rises to PT at home and falls to P*T (= PT – t) at Foreign until
the price difference is equal to t. Note that the increase in the domestic Home price is less than
the tariff, because part of the tariff is reflected in a decline in Foreign’ s export price

 The net effect is ambiguous and depends on the magnitude of the terms of trade effect (e) and
the inefficiency loss (d + e).

Consumer loss = - (a + b + c + d)
Producer gain = +a

Government revenue gain = + (c + e)

Net Welfare = -b-d +e

Answer 2c:

A demand reversal is when high domestic demand for a product in which a country has a relative
(cost) and hence price advantage based on favourable (high) supply/production considerations are
reversed such that the relative (cost) and hence price comparative advantage is undermined. A
factor-intensity reversal in a commodity’s production is experienced when a commodity’s intensity
in factor use is dependent on the relative prices of the factors available. Suggesting a commodity
could for the purposes of illustration be capital-intensive in production when the relative price of
capital to labour is low and yet labour-intensive in production when the relative price of capital to
labour is high.

It is highly doubtful that either of these reasons could be forwarded as possible explanations for the
Leontief type finding in respect of South Africa’s export position.

In reality, South Africa’s exporting of goods that are human and physical capital-intensive reveals
her as being richly endowed with these factors with in a global context which does not support the
H-O theory predictions. Furthermore the poor export performance of South Africa’s
manufacturing sectors which are labour and raw materials intensive is also a surprise as the HO
theory would predict a strong comparative advantage on the part of South Africa in these goods
within a global context.

South Africa’s actual trade position does not reflect her relative global resource endowment
position rendering the H-O theory inaccurate in predicting the source/s of her comparative
advantage. Rather the country’s trade position reflects a Leontief-type mismatch with
endowments in that exports are intensive in the use of her relatively scarce productive factors as
viewed from a global perspective.
SECTION B: Multiple Choice Questions
Answer Key:

Qu A B C D E Omit Facility Discrim

Index Index

1 27 16 16 15 27* 6 0.25 0.41

2 59 19 10 11* 7 1 0.09 0.10

3 13 16 14 41 20* 2 0.19 0.14

4 7 13 35* 36 10 6 0.33 0.45

5 55* 28 15 3 4 2 0.51 0.38

6 57* 15 15 16 4 0 0.53 0.31

7 3 11 26 45 19* 3 0.18 0.31

8 79* 19 4 4 0 1 0.74 0.62

9 8 8 9 20 62* 0 0.58 0.59

10 4 2 31 48* 20 1 0.45 0.48

11 7 10 21 58* 8 2 0.54 0.55

12 4 64* 8 14 16 1 0.60 0.48

13 29 37* 23 6 10 2 0.35 0.17

14 11 22 5 58* 9 2 0.54 0.76

15 25 30* 18 11 18 5 0.28 0.28